What is Decentralized Finance (DeFi)?
Decentralized DeFi Definition
Decentralized Finance (DeFi) is a financial system through which financial products can be used on a public decentralized blockchain network, making them open for use by anyone, rather than through an intermediary such as a bank or broker. Unlike a bank or brokerage account, no government-issued ID, Social Security number or proof of address is required to use DeFi. More specifically, DeFi refers to a system through which software written on a blockchain allows buyers, sellers, lenders and borrowers to interact peer-to-peer or with strictly software-based intermediaries, rather than the company or institution facilitating the transaction.
A variety of technologies and protocols are used to achieve the goal of decentralization. For example, decentralized systems can consist of a combination of open source technologies, blockchain, and proprietary software. Smart contracts that automate the terms of agreements between buyers and sellers or lenders and borrowers make these financial products possible. Regardless of the technology or platform used, the DeFi system aims to eliminate intermediaries between counterparties.
While the volume of transaction tokens and funds locked in smart contracts in its ecosystem has been steadily grows, DeFi is an emerging industry and its infrastructure is still under construction. Regulation and oversight of DeFi is minimal or non-existent. However, in the future, DeFi is expected to take over and replace the orbit of modern finance.
What is DeFi?
The use of technology in financial services is nothing new. Today, most transactions in banks or other financial services companies are done with the help of technology. However, the role of technology is limited to being a facilitator of such transactions. Firms must still deal with the legal jargon of jurisdictions, competing financial markets and different standards to make transactions possible. With its stack of commonly used software protocols and the public blockchain on which they are built, DeFi puts technology front and center for transactions in the financial services industry.
DeFi is often placed in the blockchain and cryptocurrency space. But its scope is much broader. To understand the thought process that led to the development of decentralized finance, it is important to understand the current state of the financial ecosystem.
The modern financial infrastructure is built on a "hub-and-spoke" model. Major centers of economic activity such as New York and London act as operational centers for the financial services industry and influence economic activity in the spokes - regional centers or financial powerhouses such as Mumbai or Milan, which may not be as globally important as the hubs, but still function as the nerve center of their respective economies.
Economic prosperity or hardship radiates outward from the hubs and then to the rest of the global economy. This pattern of interdependence is repeated in the operations of global financial services firms. They have headquarters in hubs and local branches, partnerships or investments around the world. The spread of their operations means that the organization itself is subject to a plethora of laws and regulations in each of its financial jurisdictions. Their influence makes such institutions systemically important for maintaining global economic equilibrium and necessary for maintaining or creating new financial services infrastructure.
While this model worked well over the last century, the financial crisis and subsequent Great Recession revealed the flaws in this structure. Balance sheet problems at several large financial institutions produced a domino effect of economic downturn and global recession.
Decentralized finance uses technology to eliminate the intermediaries of the centralized model and enables the provision of financial services to anyone, anywhere, regardless of race, age or cultural identity. DeFi services and applications, mostly built on public blockchains, either replicate existing products based on common technology standards or offer innovative services custom-designed for the DeFi ecosystem. At the same time, DeFi applications offer users more control over their money by explicitly catering to individual users rather than institutional personal wallets and transaction services.
What are the components of DeFi?
Broadly speaking, the components of DeFi are the same as those of the existing financial ecosystem, which means they require a stable currency and a wide range of use cases. DeFi components take the form of stable coins and services, such as crypto swaps and lending services. Smart contracts provide the framework for the operation of DeFi applications, as they encode the terms and activities required for the operation of these services. For example, smart contract codes have specific codes that are used to determine the exact terms and conditions of a loan between individuals. If certain terms or conditions are not met, the collateral may be liquidated. All of this is done through specific codes, rather than manually by banks or other institutions.
All components of a decentralized financial system belong to a software stack. Each layer of components is designed to perform a specific function when building a DeFi system. Composability is a defining characteristic of the stack, as components belonging to each layer can be combined together to form a DeFi application.
The following is an overview of the four layers that make up the DeFi stack.
Settlement layer: The Settlement layer is also known as Layer 1 because it is the base layer on which other DeFi transactions are built. It consists of the public blockchain and its native digital currency or cryptocurrency. Transactions that occur on a DeFi application are settled using this currency, which may or may not be traded in the public market. An example of a settlement layer is Ether and its native token, Ether (ETH), which is traded on the Cryptocurrency Exchange. A settlement layer may also have a tokenized version of an asset, such as a U.S. dollar, or a token that is a digital representation of a real-world asset. For example, a real estate token might represent ownership of a piece of land.
Protocol layer: Software protocols are standards and rules written to manage specific tasks or activities. In parallel with real-world institutions, this would be a set of principles and rules that all participants in a given industry agree to follow as a prerequisite for doing business in that industry. DeFi protocols are interoperable, meaning that multiple entities can use them simultaneously to build services or applications. The protocol layer provides fluidity to the DeFi ecosystem. An example of a DeFi protocol is Synthetix, an ethereum-based derivatives trading protocol. It is used to create synthetic versions of real-world assets.
Application Layer: As the name implies, the application layer is where consumer-facing applications reside. These applications abstract the underlying protocols into simple consumer-centric services. The most common applications in the cryptocurrency ecosystem, such as decentralized cryptocurrency exchanges and lending services, are located in this layer.
Aggregation layer: The aggregation layer consists of aggregators, which connect various applications in the upper layers to provide services to investors. They enable, for example, seamless fund transfers between different financial instruments to maximize returns. In a physical setup, such trading operations would require a lot of paperwork and coordination. But a technology-based framework should smooth the investment track and allow traders to quickly switch between different services. Lending is one example of a service that exists in the aggregation layer. Banking services and crypto wallets are other examples.
The current state of DeFi
Decentralized finance is still in the beginning stages of its development. As of January 2022, the total value locked up in DeFi contracts exceeds $100 billion. The total value locked in is calculated by multiplying the number of tokens in the agreement by their dollar value. While the total amount of DeFi may sound large, it is important to remember that it is nominal, as many DeFi tokens lack sufficient liquidity and trading volume to be traded in the crypto market.
The DeFi ecosystem is still rife with infrastructure incidents and hacking attacks. Scams also abound in the fast-growing DeFi infrastructure. DeFi "carpet-pulling," where hackers deplete funding protocols and investors are unable to trade, is common, despite the availability of well-established protocols that significantly reduce this risk.
The open and relatively decentralized nature of the decentralized financial ecosystem may also pose problems for existing financial regulation. Current laws are based on the idea of independent financial jurisdictions, each with its own set of laws and rules. DeFi's borderless span of transactions raises important questions for such regulation. For example, who is responsible for financial crimes that occur across borders, protocols and DeFi applications?
For example, what if incorrect input causes the system to crash? Or, what if the compiler (which is responsible for compiling and running the code) makes an error. Who is responsible for these changes? These and many other issues need to be addressed before DeFi can become a mainstream system used by the general public.
What are the benefits of decentralized finance?
Decentralized finance leverages the key principles of blockchain to improve financial security and transparency, unlock liquidity and growth opportunities, and support an integrated and standardized economic system.
Highly programmable smart contracts automate execution and support the creation of new financial instruments and digital assets.
2. Security and auditability
Tamper-proof data orchestration across the decentralized architecture of the blockchain improves security and auditability.
Ethernet's composable software stack ensures that DeFi protocols and applications are built to integrate and complement each other. With DeFi, developers and product teams have the flexibility to build on top of existing protocols, customize interfaces and integrate with third-party applications. For this reason, the DeFi protocol is often referred to as a "money Lego block".
On the public ethereum blockchain, each transaction is broadcast to and verified by other users on the network (note: ethereum addresses are pseudo-anonymous cryptographic keys). This transparency around transaction data not only allows for rich data analysis, but also ensures that any user can use the network activity. Ethernet and the DeFi protocol running on it are also built using open source code that can be viewed, audited and built by anyone.
Unlike traditional finance, DeFi is defined by open, permissionless access: anyone with a crypto wallet and an Internet connection, regardless of geographic location and often without any minimum amount of capital, can access DeFi applications built on Ether.
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